How it works
A DCF has four steps. Forecast free cash flow for a period, often five to ten years. Estimate a terminal value for the years after that. Choose a discount rate, usually the WACC. Then add up the present values of the cash flows and of the terminal value to get enterprise value. Subtract net debt to reach equity value.
DCF is popular because it focuses on cash and forces you to state your assumptions. It is also sensitive. Small changes to growth or to the discount rate can change the answer a lot, so results should be tested with sensitivity tables.
Enterprise value = Sum of [Free cash flow in year t ÷ (1 + WACC)^t] + Terminal value ÷ (1 + WACC)^n
A simple example
How it is used
- Valuing businesses that have forecastable cash flows.
- Valuing projects and acquisitions.
- Testing what growth a share price implies.
Common mistakes
- Over-optimistic forecasts.
- A terminal value that is too large, or growth that is too high.
- A discount rate that does not match the risk or the currency.
- Forgetting to subtract debt to get from enterprise value to equity value.
Questions
What is the difference between DCF and NPV?
They use the same idea. NPV discounts the cash flows of a project and subtracts the cost. A DCF applies that idea to a whole business to find its value.
When does a DCF not work well?
When cash flows are very uncertain, for example in early-stage companies or businesses in deep trouble. Banks and insurers also need special approaches.
Keep learning
- What is terminal value?
- What is WACC (weighted average cost of capital)?
- What is free cash flow (FCF)?
- What is enterprise value?
- Guide: Business valuation
- Cost of equity and WACC calculator
- Damodaran: costs of capital by sector
- Glossary: Discounted cash flow (DCF)
- Glossary: Discount rate
- Glossary: Free cash flow (FCF)
- Glossary: Terminal value
- Glossary: Weighted average cost of capital (WACC)